Valuing strategic flexibility with Black-Scholes option pricing model

Abstract

Purpose: The purpose of the research paper is to present a real option valuation model that will help to identify the value drivers of the JSC Rietumu Banka: one of the biggest Latvian banks that specializing in private and investment banking as well as measure the value of its strategic flexibility.

Design/methodology/approach: The empirical research appears to be correlational one as it is to study and describe issues related to Real Options Valuation – both general: application and comparison to DCF method and specific: value of JSC Rietumu Banka and the value of strategic flexibility. The rationale behind choosing a commercial Bank as a unit of research has a number of reasons. The model of Black-Scholes of option pricing is very topical for valuing companies, assets and liabilities of which are relatively comparable and continuously change in value. Thus, JSC Rietumu Banka was chosen specifically, because it is known for being more active in corporate investing activities than other commercial banks in Latvia.

Findings: The research outcomes of the paper were divided into three parts accordingly to the research questions. The first part was dedicated to estimating the value of the Bank through traditional DCF approach. The second part was answering the research question by identifying the equity value of the bank using Real Options Valuation through Black-Scholes option pricing model. The third part was dedicated to identifying implications behind valuation of a commercial bank using ROV. The main drivers that determine value of a bank and its strategic flexibility were explained and discussed.

Research limitations/implications: The main data needed for the research are financial statements for JSC Rietumu Banka. Financial reporting for company includes statements for the Bank and not for the Group. Limitation of this approach is the quantification. Real option evaluation of strategies can get lost in the mathematics.

Practical implications: There are few academic works on the topic, yet none of the major companies in the Latvia have publicized ROV application. However, the value of strategic flexibility appears to play a pivotal role nowadays, given the transition condition of Latvian economy. Furthermore, bankers can benefit from using ROV methods when analyzing and selecting the strategic alternatives.

Social implications: The paper is to sketch the outlines of a more differentiated approach towards the contribution Strategic Management and Financial Management which can help to most managers and their needs to replace traditional approaches to strategic planning and company valuation with a more aggressive one in transition economy settings.

Originality/value: Surprisingly, very few paper and books have discussed the valuation of the bank. Even in bestselling book on valuation of companies written by Koller et al, 2010, there is no example of Real Option Valuation for a bank valuation.

Classification: research paper
All business decisions are real options, in that they confirm the right but not the obligation to take some initiative in future. Judy Lewent, CFO, Merck